2009-2010 Momentum

In the long run (20+ years), the stock market converges to the value of the future discounted cash flows of its earnings over time, which is either paid out in dividends or indirectly through stock buybacks.  But in the intermediate and short run, the stock market can converge or diverge from its "fair valuation".  That fair valuation is debatable, but using historical valuations is a fairly good barometer for what is fair. 

I'd like to talk about the short to intermediate time frame.  This can be anything under 5 years.  In that time frame, which most traders are focused on, valuation is a small factor compared to momentum, trader sentiment, and short term news / events.  This brings me to the current stock market.  We have been rallying hard and continuously for over 1 year, and to many, it is unbelieveable because unemployment is still high, the housing market is still weak, and the economy isn't booming.  It is a huge wall of worry that the market has been climbing.  That has prevented this market from bringing in weak handed speculators who are easily shaken out by selloffs.  The 2008-2009 bear market shook out those weak hands.  The speculators and investors on board and in the market will not be easily shaken out.  I repeat, these investors will not be easily shaken out.  That is why the dips have been so fleeting, and the weakness so quickly bought.  The weak hands already sold. 

But things are starting to change.  The market doesn't change on a dime, but its character changes gradually.  These shifts take time.  When the shift is complete, you get a sharp correction.  With the recent surge in equity call activity and the increasingly complacent behavior of investors, we are using up what time we have left before this market becomes more two sided.  It has been one-sided for over a year, and the signs of change are visible.  The world markets are lagging the US, or breadth on a world scale for equities is weakening.  US is strong, but Asia and Europe are lagging.  The small caps have outperformed in this recent leg up, another sign that investors are reaching out for risk and return. 

While things are lining up for a turn in the market, we have to remember that momentum is a powerful beast in the market.  The stronger the momentum, i.e. 1995-2000, 2003-2007, the more likely it is to continue.  And this market has very strong momentum.  So how to handle a momentum market beast?  Well, I would recommend following the uptrend, but the signs I mentioned above tell me that it is late in the momentum game.  Yet, it still feels early based on anecdotal evidence and overall dissatisfaction with the economy and jobs.  Ultimately, I'd like to see investors more positive on the economy and jobs before I am comfortable with an intermediate term short position.  Yes, that is a very contrarian stance, and contrarians usually get crushed in trending markets.  But from a very long term point of view from 2000 to present, going short follows the trend of lower equity prices and lower valuations.